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Graphical models for correlated defaults

Author

Listed:
  • I. Onur Filiz
  • Xin Guo
  • Jason Morton
  • Bernd Sturmfels

Abstract

A simple graphical model for correlated defaults is proposed, with explicit formulas for the loss distribution. Algebraic geometry techniques are employed to show that this model is well posed for default dependence: it represents any given marginal distribution for single firms and pairwise correlation matrix. These techniques also provide a calibration algorithm based on maximum likelihood estimation. Finally, the model is compared with standard normal copula model in terms of tails of the loss distribution and implied correlation smile.

Suggested Citation

  • I. Onur Filiz & Xin Guo & Jason Morton & Bernd Sturmfels, 2008. "Graphical models for correlated defaults," Papers 0809.1393, arXiv.org.
  • Handle: RePEc:arx:papers:0809.1393
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    File URL: http://arxiv.org/pdf/0809.1393
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    References listed on IDEAS

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    1. Yu, Fan, 2005. "Accounting transparency and the term structure of credit spreads," Journal of Financial Economics, Elsevier, vol. 75(1), pages 53-84, January.
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    5. M. Davis & V. Lo, 2001. "Infectious defaults," Quantitative Finance, Taylor & Francis Journals, vol. 1(4), pages 382-387.
    6. Robert A. Jarrow & Fan Yu, 2008. "Counterparty Risk and the Pricing of Defaultable Securities," World Scientific Book Chapters, in: Financial Derivatives Pricing Selected Works of Robert Jarrow, chapter 20, pages 481-515, World Scientific Publishing Co. Pte. Ltd..
    7. Jeffery D Amato & Jacob Gyntelberg, 2005. "CDS index tranches and the pricing of credit risk correlations," BIS Quarterly Review, Bank for International Settlements, March.
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    Cited by:

    1. Fred E. Benth & Geir Dahl & Carlo Mannino, 2010. "Computing optimal recovery policies for financial markets," DIS Technical Reports 2010-20, Department of Computer, Control and Management Engineering, Universita' degli Studi di Roma "La Sapienza".

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